S&P criticises austerity policy

Euro zone leaders are trying to play down cuts to the credit ratings of nine countries over the weekend which cost France its AAA, but the move by Standard & Poor’s could force significant changes to their strategy for defending the common currency.

The ratings agency downgraded Cyprus, Italy, Portugal, and Spain by two notches, pushing Italy to the same level as Kazakhstan. It also lowered its long-term ratings on Austria, France, Malta, Slovakia and Slovenia by one notch, booting Austria and France, a G-7 country and the second-biggest economy in the euro zone, off the top ranking.

The downgrade was widely expected and some took comfort that other key countries such as Germany and Holland retained their AAA.

But the decision places added pressure on the bailout mechanism for struggling countries and casts doubt on the German-inspired strategy of cutting budget deficits regardless of the impact on the economy.

S&P says this strategy reflects a partial diagnosis and structural reforms and short-term stimulus could also play a role.

“We believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues," S&P analyst Moritz Kraemer said in announcing the downgrades.

German Chancellor
Angela Merkel
paid little attention, saying that the downgrades reinforced the need for a euro zone fiscal compact to enforce yet more budget austerity.

She gave little sign of whether Germany would try to stop a second-round downgrade, which is expected this week to the bailout fund that is supposed to ease the pressure on struggling euro zone countries.

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With France now no longer on a AAA, S&P has warned it will within days cut the AAA rating of the €440 billion European Financial Stability Facility, guaranteed by the euro zone governments including France. If the EFSF faces higher borrowing costs it will have to pass them on to debtor countries such as Ireland or Portugal.

Germany could save the EFSFs AAA by increasing the €212 billion it has pledged but Dr Merkel said over the weekend that she saw no need for change to the EFSF.

On the other hand, Dr Merkel talked of speeding up the creation of a longer-term bailout fund to be called the European Stability Mechnism, but that won’t be in effect for at least five months. Euro zone leaders have long questioned rating agencies’ wisdom and Dr Merkel, speaking at a party conference in the northern city of Kiel, suggested she might embrace changes which reduced their influence. “I think it is very useful to look at this and see where if necessary we can make changes to legislation," Dr Merkel said.

Neither Fitch nor Moody’s have followed S&P in cutting France’s AAA. Economists also say markets have long priced in the downgrades.

They say interest rates on US treasury bonds have fallen since October when the US lost its AAA.

France’s Prime Minister, François Fillon, said he would do everything to regain the top ranking.

But with a presidential election looming in three months, his boss President
Nicolas Sarkozy
who passed austerity measures last year to save the AAA, may now decide to ease off for a while.

France faces a key test today when it plans to raise over €8 billion in a debt auction. Despite the looming threat of a downgrade, European government borrowing costs have fallen recently and Italy and Spain last week borrowed €15 billion at lower than expected interest rates.

One key reason is that the European Central Bank last month softened its stance, cutting official rates and lending about €500 billion to banks, easing the risk of a credit crunch or a banking collapse.

“We believe that euro zone monetary authorities have been instrumental in averting a collapse of market confidence," Mr Kraemer said.

Prime Minister
Julia Gillard
seized on the downgrade to boast about Australia’s recent success in winning back a AAA from all three credit rating agencies.

“For too many years, European governments have deferred the nation-building productivity enhancing reforms which Australia has made the foundation of our dynamic and resilient economy," Ms Gillard said.